LegalFund sees another way to the top

New questions are being asked about the controversial $6 million
LegalFund
float. The litigation funder and law firm issued a replacement prospectus after the Australian Securities and Investments Commission required more director disclosure.

The Australian Financial Review raised questions in May about the experience of Bruce Dennis, LegalFund managing director and major shareholder, in class actions. LegalFund told the AFR this week that of six class actions completed by the firm, one returned money for clients and three arranged for lenders not to pursue loans.

LegalFund’s broker presentation says DC Legal, a law firm acquired by LegalFund, has a “successful track record with class-action litigation".

ASIC has since approved the float, a sore point with critics of LegalFund.

AFR
AFR

The AFR asked LegalFund for its original prospectus, to compare it with the replacement prospectus.

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A spokesman said the earlier draft was not registered and no longer existed. It appears claims about LegalFund’s class-action record have moderated. LegalFund’s main selling point is growth in litigation funding as more class actions emerge after the global financial crisis.

Australia’s largest listed litigation funder,
IMF
(Australia), had a case investment portfolio with an estimated claim value of $1.4 billion at June. The goal is $2 billion within 12 months.

Litigation funders receive a share of successful claims, typically 30 per cent to 50 per cent, depending on case risk.

IMF
had $63.2 million revenue in financial 2009 and $20.8 million net profit. The stock’s three-year average annual total return is 41 per cent.

IMF’s strong performance has established litigation funding as an alternative asset class in Australia and has encouraged competition, mostly from unlisted enterprises. Listed competitors include
Hillcrest Litigation Services
, capitalised at $3 million, and, soon, LegalFund, with an $11.5 million valuation. IMF is worth $188 million.

LegalFund wants to “dominate mid-market" by targeting 25 to 50 smaller liquidator claims annually, each between $500,000 and $2 million, and up to three class actions for much larger amounts.

IMF targets cases with claims above $2 million. LegalFund says this has created a gap for it to fund smaller litigations.

The AFR understands LegalFund earns net income of $200,000 to $300,000 on each successful case. Assuming an 80 per cent success rate, LegalFund would have net income of about $4 million (based on 20 cases settling in a year) within a few years.

And DC Legal could increase a small profit through referrals from the litigation funding business. Total net profit above $3 million after corporate overheads would make LegalFund’s valuation appear conservative. But investors must examine the firm’s assumptions.

Litigation funders are likened to fund managers because they manage a portfolio of cases with different risk profiles and maturities. They survive on their ability to choose the right cases.

Success rates above 80 per cent impress, but a few bad cases can kill smaller players.

The judgment in the Supreme Court of Western Australia last month against IMF’s client, the trustee of the Kingstream Steel Creditors’ Trust, in an action against
St Barbara
, shows the dangers.

IMF spent $1.5 million funding the case and hoped to receive $4.5 million. The negative verdict resulted in a $6 million turnaround for IMF for a mid-range case by claim size.

Litigation funding is a complex business built around people. Choosing the right cases and managing case-risk profiles, maturities, portfolios and funding takes great skill. Record and reputation are everything. LegalFund’s limited experience and modest class-action record, and the fact it did not lead or run test cases for most class actions in which it participated, could affect its ability to attract higher-quality cases from the best liquidators.

Balance sheet is another consideration. LegalFund’s unaudited pro forma balance sheet shows cash of $5 million after the float. A further $7.1 million will be raised if 28.7 million options are exercised before 2013. Other cash will arrive as LegalFund receives fees from successful cases.

Case volume assumptions greatly affect profit.
LegalFund
believes it will fund and settle 15 to 20 cases in its first year as a listed company, rising to 25 to 50 cases.

Industry observers believe $5 million in cash in 2010 would at best fund 10 cases below $2 million in claims, using high quality external legal advice. For every dollar in funding, litigation funders set aside another dollar to cover the other side’s costs, should the funder lose the case.

LegalFund’s cash flow timing and plan to target liquidators in the final stages of cases are other risks. LegalFund believes cases it funds will settle within a year. Industry watchers say even small claims average two or three years to settle. Delays would damage LegalFund’s cash flow.

The company’s strategy has confounded some fund managers who believe IMF moved away from claims below $2 million because they were unprofitable. LegalFund could be funding cases that larger litigation funders avoid. Offer costs of almost $1.1 million, high for a $6 million capital raising not underwritten, may reflect the risks.

Unusually, LegalFund changed advisers during its float. The AFR understands the original lead manager, YBR Securities, part-owned by finance entrepreneur Mark Bouris, withdrew from the float after it received bad publicity.

To be fair, LegalFund has a different business model to other funders. Owning a stand-alone law firm, which requires a significant potential conflict of interest to be managed and increases regulatory risk, could result in LegalFund doing more work internally and operating a lower cost structure than bigger litigation funders.

If it can achieve this model and maintain success rates, LegalFund could make a reasonable profit by funding a large number of lower risk, lower-return cases. Limited experience in large class actions may count less against the firm in some liquidation matters that large funders avoid.

Investors must assess LegalFund’s challenges against a valuation that rises from $11.5 million to $21.1 million on a fully diluted basis if options are exercised.

And they must avoid comparisons with IMF, which is now a popular stock. However, it took five years to pay a dividend and get serious market traction. LegalFund wants to pay a dividend within two years.